Midterm Examination, BUS312, D1. SFU Student number:

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1 Midterm Examination, BUS312, D1 NAME: SFU Student number: Instructions: For qualitative questions, point form is not an acceptable answer. For quantitative questions, an indication of how you arrived at particular numbers is required for the purpose of assigning part marks. This examination is composed of 6 questions and 6 pages (not equally marked for a total of 100). Please answer all questions on the examination. The examination period is 2 hour and 30 minutes. 1. (10 marks) A golden parachute is a clause in an executive's employment contract specifying that he/she will receive large benefits in the event that the company is acquired and the executive's employment is terminated. These benefits can take the form of severance pay, a bonus, stock options, or a combination thereof. How do you think a golden parachute clause affects the agency problem between shareholders and managers? 2. In year 1 of your new business as a boat rental company, you have bought a motorboat for $100,000 and a sailboat for $80,000 (both are asset 7, which carries a 15% CCA rate). After 3 years (i.e., at the beginning of year 4), you sell the motorboat for $110,000 and the sailboat for $40,000 a) (15 marks) Calculate the CCA rate for year 1, 2, and 3. What is the UCC balance at the end of year 3? What is the balance after you sell the boats at year 4? b) (10 marks) What are the tax consequences at year 4? Assume a 40% corporate tax rate. 3. (15 marks) A firm wishes to maintain an internal growth rate of 10% and a dividend pay-out ratio of 70 percent. The current profit margin is 6% and the firm uses no external financing. What must total asset turnover be? 4. (5 marks) Joe Canoe is a rancher. His herd of cattle (or any other herd of cattle) is not allowed a capital cost allowance by the government. In the government s eyes, this asset is not depreciable. Comment on the following assertion: If this asset is not depreciable, it cannot be a real asset, and therefore, it must be a financial asset. Use no numerical examples in your response. 5. A firm has an asset turnover (sales/total asset) ratio of 2.0. Its plowback ratio is 50%, and it is all-equity financed. a) (8 marks) What must its profit margin be if it wishes to finance 8% growth using only internally generated funds. (hint: think what an all equity financed firm means about ROE s relation to ROA). b) (7 marks) If the profit margin was only 6%, what is the maximum payout ratio that will allow it to grow at 8% growth using only internally generated funds? c) (7 marks) If the profit margin of the firm is 6%, what is the maximum growth rate possible without resorting to external financing?

2 6. The following information is available on the financial accounts of ABC Corporation: YEAR From Income Statement Sales Cost of good sold Dividends 654 From Balance Sheet Current assets Net fixed assets 7320 Short term debt Current liabilities Long term debt At the end of 2001, ABC s incremented its short term debt (borrowed) by $240 and its long term debt by 200. Because this borrowing was at the end of 2001, interest expenses for 2001 are calculated on the beginning of 2001 balance (end of 2000). The interest rate on ABC s short-term debt is 9% per annum, and the interest on long term debt is 5% per annum. ABC made capital expenditures of $450 at the end of Because these capital expenditures were at the end of 2001, ABC s depreciation expense for 2001 is a 5% rate for deprecation times net fixed assets at the beginning of 2001 (end of 2000) prior to the capital expenditure. ABC s tax rate is 40%. a. (15 marks) Calculate the cash flow from assets for the year b. (10 marks) Assuming that the firm repurchased shares (equity) for $500 during 2001, what were the dividend payments in 2001.

3 1. A golden parachute increases the agency problem. The shareholder s objective is that the firm maximize its value, i.e., maximize its share price. One of the disciplining tools that induce managers to maximize value is the takeover market. The fear from a takeover makes managers maximize value. If they do not maximize value, the firm will be targeted by other market participants, who believe that they can takeover the firm and replace its executives by more competent managers. By doing so the share price should increase and the bidders could make a profit. However, it there is a golden parachute clause, the firm will also have to pay the incumbent managers high benefits when it replaces them. This reduces the profitability for the bidders to engage in the takeover. The result is that the takeover market effectiveness as a disciplining device of managers is reduced if the executives have in their contract a golden parachute clause. 2) a) UCC1 = 0.5 *(80, ,000) =90,000 CCA1 = 0.15*90,000 = 13,500 UCC2 = 90,000+(90,000-13,500) =166,500. CCA2 = 0.15*166,500=24,975 UCC3 = = CCA3 = 0.15*141525= UCC4 (end year 3) = = UCC5 (end year 4) = = b) tax consequences: Selling the motorboat results in capital gain of (110, )*.5*.4=2,000 After the sales in year 4, there is recaptured loss of Thus, we should add this amount to taxable income. Extra tax = *.4 = ) g=0.10, b = = 0.3, p = g = ROA b / (1 - ROA b) ROA = g / (b (1+g)) = 0.10/( ) = ROA = NI / A, p = NI / S ROA/p = S/A = /0.06 = Whether or not CCA can be taken is not a defining characteristic of a real asset. Rather, the herd of cattle seems to satisfy our definition of a real asset given in class. Real assets (1) not established by legal contract between specific individuals and, such that there are no contractually promised payments between specific individuals. (2) it must be managed to produce a return. A cow is not an asset which is established by a legal contract between specific individuals, the ownership of a cow is transferred once the cow is purchased. A cow must also be managed to produce return. Thus, in order to generate cash flow (milk, meat) you need to feed and care for it. 5. a) g=roa*b/(1-roa*b)

4 Since the firm is all equity financed A=E (Crucial point of the problem) and ROE=ROA Du Pont; S/A = 2, b=0.5, A/E=1 ROE= NI/S * S/A * A/E = p * 2 * 1=2p, where p-profit margin g=roa*b/(1-roa*b)=(2p*b)/(1-2p*b) = p/(1-p)= g g*p = p p=g/(1+g) =.08/1.08 =.07407% b) ROE = ROA = 2*.06=.12 8% = b(0.12)/(1-.12b) *.08*b=0.12b.08=.1296b b= c) For maximum growth rate set b=1; g=roa/(1-roa) =.12/(1-.12) =.12/.88 = (a) Interest (2001) = = 200 Dep (2001) = = 366 NFA (2001) = = 7404 Short term debt (2001) = = 740 Long term debt (2001) = = 3300 Income statement 2001 Sales 4500 COG 2534 DEP 366 EBIT 1600 INT 200 EBT 1400 Tax(40%) 560 Net Income 840 OCF=EBIT+DEP-TAX = = 1406 Addition to NWC = (Ending NWC) (Beginning NWC) =( ) ( ) = = -70 Net Capital Spending = = 450 (can be seen immediately from question) Cash flow from assets = 1406 (-70) 450 = 1026 (b) Cash flow from assets = cash flow to bondholder + cash flow to equity holders = extra debt issue + interest + dividends+ new equity issued

5 dividends = Cash flow from assets + net long term borrowing interest- new equity issued dividends = = 526